PRODUCTION FUNCTION

AND
COST CONCEPTS

- Vijun Karthick SN
 SUPPLY
Definition

 Supply refers to the quantity of a commodity which

producers or sellers are willing to produce and offer for
sale at a particular price’, in a given market, at a
particular period of time

Three important aspects

 Supply is a desired quantity

 Supply is always explained with reference to price

 Supply is a flow variable

 STOCK AND FLOW CONCEPTS
Stock variable Flow variable

 It is an economic  It is an economic
variable which can variable which can
be measured at a be measured at a
point of time. period of time.
 E.g. population,  E.g. National
water in a reservoir, income, water in a
warehouse goods river, sales etc.
 INDIVIDUAL AND MARKET SUPPLY
Individual supply refers to the
quantity of a commodity
which a firm is willing to
produce and offer for sale at a
particular price during a
specified period.

Market supply refers to the

quantity that all the producers
are willing to produce and
offer for sale at a particular
price during a specified
period. It is the sum total of
individual supply
 STOCK AND SUPPLY CONCEPT

Stock Supply

 Stock is the total  Supply is that part of

quantity of a
commodity available
with the producers
which is ready for sale.
 Stock is not a part of
supply
 Supply depends on
stock which the
producers are willing to
bring to the market and
offer for sale at a
particular price.
stock.
 DETERMINANTS OF SUPPLY
 Price of the commodity
 Goals of the firm
 Input prices
 Prices of related commodities
 Techniques of production
 Nature of the market
 The policy of taxation and subsidies
 Expectations about future prices
 Agreement among producers
 Availability of transport and communication facilities
 PRODUCTION
Definition

 Production process involves the transformation of inputs

into output

Aspects

 Inputs could be land, labour, capital, entrepreneurship etc.

 An entrepreneur must put together resources -- land,
labour, capital -- and produce a product people will be
willing and able to purchase
 output could be goods or services
 PRODUCTION - INPUT
Input Factors
 Land is all natural resources of the earth. E.g. Price paid to
acquire land = Rent
 Labour is all physical and mental human effort involved in
production. E.g. Price paid to labour = Wages
 Capital is buildings, machinery equipment which contributes to
the production. E.g. Price paid for capital = Interest

Inputs Process Output

Land Product or
service
Labour
generated
Capital – value added
 PRODUCTION - INPUT

Fixed Variable

 A Fixed input is one  Variable input is one

whose quantity cannot be
changed instantaneously
in response to changes in
market conditions
requiring an immediate
change in output.
whose quantity can be
changed readily when
market conditions suggest
that an immediate change
in output is beneficial to
the producer.

 Example - Buildings,  Example - Raw materials

equipment managers etc. and labour services.
 PRODUCTION FUNCTION

 A production function is the functional and technological

relationship between inputs and output. The maximum
output which can be obtained for a given combination of
inputs
 The production function for a firm can be represented as

Q = f (x1, x2, ….,xn)

 Where Q is the maximum quantity of output, x1, x2, ….,xn
are the quantities of various inputs, and f is the functional
relationship between inputs and output.
 If there are only two inputs, capital (K) and labour (L), the
production function is represented as Q = f (L, K)
 SHORT RUN AND LONG RUN
Short Run

 It is defined as that period of time in which quantity of one or

more inputs remains fixed irrespective of the volume of output.
 Example - Using more raw material and employing an increased
number of workers with the existing plant and equipment.

Long Run

 It refers to that time period in which all inputs are variable

 Example - Installation of additional machine and employing more
workers
 PRODUCTION IN SHORT RUN
Definition

 Short run is a period of time over which at least one factor

must remain fixed
 It is a period of time over which output can be changed by
adjusting the quantities of resources such as labour, raw
material, fuel to meet the rising demand of the good but
fixed resource i.e. the size or scale of the firm remains fixed

Production in Short Run is a short period in which at least

one resource (Plant, machines) is fixed or inelastic. The
production of a commodity can be increased by increasing
the use variable inputs like labour and raw materials.
PRODUCTION FUNCTION ANALYSIS: SHORT RUN
 In the short run at least one
factor fixed in supply but all
other factors capable of
being changed
 Reflects ways in which firms
respond to changes
in output (demand)
 Can increase or decrease
output using more or less of
some factors but some
flexible to change
 Increase in total capacity is
not possible
PRODUCTION FUNCTION SHORT RUN

In times of rising sales

(demand) firms can increase
labour and capital but only up
to a certain level – they will be
limited by the amount of
space. In this example, land is
the fixed factor which cannot
be altered in the short run.

If demand slows down,

the firm can reduce its
variable factors – in this
example, it reduces its
labour and capital but
again, land is the factor
which stays fixed.
 COST CONCEPT
Definition

 It is used for analyzing the cost of a project in short and

long run
Types

 Fixed Cost
 Variable Cost

 Total Cost

 Marginal Cost
 COST CONCEPT
Fixed Cost
 Fixed Cost denotes the costs which do not vary with the level of
production. FC is independent of output
E.g. Depreciation, Interest Rate, Rent, Taxes
 Total fixed cost (TFC): All costs associated with fixed input.

 Average fixed cost/ unit of output: AFC = TFC /Output

Variable Cost
 Variable Costs is the rest of total cost, the part that varies as you
produce more or less. It depends on Output
E.g. Increase of output with labour
 Total variable cost (TVC): All costs associated with variable input

 Average variable cost/ unit of output AVC = TVC/ Output

 COST CONCEPT
Total Cost
 The sum of total fixed costs and total variable costs:
TC = TFC +
TVC
 Average Total Cost/ unit of output:

ATC = AFC + AVC/ ATC = TC/ Output

Marginal Cost
 The additional cost incurred from producing an additional unit
of output:
MC =  TC/  Output
MC =  TVC/  Output
COST CONCEPT
 STOCK AND SUPPLY CONCEPT
Average Fixed Cost Marginal Cost

 AFC is always declining at  MC is generally increasing.

a decreasing rate.  MC crosses ATC and AVC at
 ATC and AVC decline at
their minimum point.
first, reach a minimum,
then increase at higher
 If MC is below the average
levels of output. value: Average value will
 The difference between be decreasing.
ATC and AVC is equal to  If MC is above the average
AFC. value: Average value will
be increasing.
PRODUCTION RULES FOR THE SHORT-RUN
 If expected selling price < minimum AVC (TR < TVC):
 A loss cannot be avoided

 Minimize loss by not producing

 The loss will be equal to TFC

 If expected selling price < minimum ATC but > minimum AVC:
(which implies i.e. TR > TVC but < TC):
 A loss cannot be avoided

 Minimize loss by producing where MR = MC

 The loss will be between 0 and TFC

 3.If expected selling price > minimum ATC (which implies TR >
TC):
 A profit can be made

 Maximize profit by producing where: MR = MC

SHORT RUN PRODUCTION DECISIONS
 PRODUCTION RULES FOR THE LONG-RUN
 If selling price > ATC (or TR > TC):
 Continue to produce

 Maximize profit by producing where: MR = MC

 If selling price < ATC (or TR < TC):

 There will be a continual loss

 Sell the fixed assets to eliminate fixed costs

 Reinvest money is a more profitable alternative

Cost Curve

 All costs are variable in the long run

 There is only AVC in LR, since all factors are variable

 It is also called as Planning Curve or Envelope or scale curve

LONG RUN COST CURVE
 ECONOMIES OF SCALE
 Economies of scale are the cost advantages that a firm obtains
due to expansion. Two types:
 Pecuniary Economies of Scale: Paying low prices because of
buying in large Quantity
 Real Economies of Scale: Reduction in physical quantities of
input per unit of output when the size of the firm increases, as
a result input cost minimized

Economies of Scale
 DISECONOMIES OF SCALE

 Diseconomies of scale are the cost disadvantages that a firm

obtains due to expansion. Two types:
 Internal Economies: It is a condition which brings about a
decrease in LRAC of the firm because of changes happening
within the firm. E.g. As a company's scope increases, it may
have to distribute its goods and services in progressively more
dispersed areas. This can actually increase average costs
resulting in diseconomies of scale
 External Economies: It is a condition which brings about a
decrease in LRAC of the firm because of changes happening
outside the firm. E.g. Taxation policies of Govt.
 COST- OUTPUT RELATIONSHIP

 Cost- output relationship has two aspects:

 Cost – output relationship in short run: The short run is a
period which does not permit alterations in the fixed
equipment and in the size of the organization
 Cost – output relationship in short run: The long run is a period
in which there is sufficient time to alter the equipment and the
size of the organization . Output can be increased without any
limits being placed by the fixed factors of production
 COST- OUTPUT RELATIONSHIP IN SHORT RUN

 It is studied in terms of:

 Average Fixed Cost: The greater the output, the lower the fixed
cost per unit i.e. the average fixed cost . Total fixed cost remain
the same and do not change with a change in output
 Average variable cost: The average variable cost will first fall
and then rise as more and more units are produced in a given
place. E.g. electricity charge , labour cost etc.
 Average Total Cost: Also known as average cost. Would decline
first and then rise upwards. Average cost consists of average
fixed cost plus average variable cost. Average fixed cost
continues to fall with an increase in output while average
variable cost first declines and then rises. When the rise in AVC
is more than the drop in average fixed cost that the average
total cost will show a rise
COST- OUTPUT RELATIONSHIP IN SHORT RUN
 COST- OUTPUT RELATIONSHIP IN SHORT RUN

 Long run period enables the producers to change all the factor
and will be able to meet the demand by adjusting supply. In the
long run we have 3 costs:
 Total Cost TC =TFC +TVC
 Average Cost AC=TC/output
 Marginal Cost: Change in TC as a result of change in output by
one unit
 When all the short run situations are combined , it forms the
long run industry. We can derive a long run cost curve by
depicting average cost of all short run (Tangency Point)
 COST- OUTPUT RELATIONSHIP IN SHORT RUN

 Demand is less and the plant’s capacity is limited. When demand

rises, the capacity of the plant is expanded.
 We use long run costs to decide scale issues, E.g. Mergers.
 We can build any size factory based on anticipated demand ,
profits , and other considerations.
 Once the plant is built , we move to the short run. Therefore , it is
important to forecast the anticipated demand. Too small a factory
and marginal costs will be high as the factory is stretched to over
produce.
 Conversely too large a factory results in large fixed costs and low
profitability
COST- OUTPUT RELATIONSHIP IN SHORT RUN